Obama: Sweep Away a Free Trade Relic

Among the most embarrassing, yet often overlooked economic policies of the Bush and Clinton years was the penchant for making other countries restrict capital controls, even though such controls had proved effective against financial volatility.

It’s not easy to make the International Monetary Fund look like a beacon of progressive enlightenment. But the Bush administration managed to do just that by letting ideology blind them to lessons from the Asian financial crisis that even doctrinaire IMF economists couldn’t ignore.

With the global economy once again in a tailspin, it’s time for the Obama administration to sweep away the relics of this myopic past. Among the most embarrassing, yet often overlooked of these holdovers are the strict limits on capital controls that have been pushed throughout the world, particularly in developing nations.

As part of a broader market fundamentalist agenda, the IMF and the U.S. government once galloped side by side in a crusade to eliminate these controls, which are various measures to reduce volatility by taxing or prohibiting certain cross-border investments. The IMF banned them through loan agreements, while the U.S. government severely restricted their use through bilateral investment treaties and the investment chapters in trade agreements.

To put teeth in their deals, U.S. officials insisted that private investors be allowed to file suit in international tribunals if governments dared to violate their “rights” to free capital mobility.

Defying the IMF Worked

Then came the Asian crisis of the late 1990s, and subsequent financial turmoil in Russia, much of Latin America, and Turkey. What the IMF couldn’t help but notice was that China, India, Chile and other countries with capital controls emerged relatively unscathed. It was also hard to overlook how rapidly Malaysia recovered, once it defied the IMF and shut the door on capital flight.

Did IMF economists immediately become rah-rah cheerleaders for capital controls? Not exactly. But as early as 2001 they lifted their blanket opposition, and in recent years they’ve advised at least two countries to strengthen one type of capital control, a reserve requirement on inflows. They also told Iceland to keep blocking outflows until the country emerges from its current meltdown.

Kenneth Rogoff, former IMF chief economist and now a Harvard University professor, acknowledged that at the World Economic Forum in Davos last week, some of the only cheerful attendees were Indian business leaders and officials, who had a “strong sense of relief that they were living far from the epicenter of the recession, insulated by their country’s size and still comparatively stringent restrictions on international capital flows.

The IMF’s shift on this particular issue coincided with growing support for the freedom to use capital controls among many noted economists, including Nobel Prize winners Joseph Stiglitz and Paul Krugman, Harvard University’s Dani Rodrik, and even Columbia University free-trader Jagdish Bhagwati.

The U.S. government, meanwhile, stuck with its crusade against capital controls. After the Asian crisis erupted in 1997, it galloped full speed ahead, initiating agreements limiting capital controls with 22 countries. Now a total of 52 nations have become bound by such pacts forged since the late 1980s. Such restrictions are, naturally, in the pending U.S.-Colombia Free Trade Agreement.

No Change Yet

Will the Obama administration reverse course? On the campaign trail, Obama committed to revising the investment rules in U.S. trade agreements, along with other proposed trade reforms. Although he didn’t mention the capital controls provisions specifically, his statements offer hope for change, particularly in the context of a financial crisis that has provoked widespread capital flight. Sixteen countries with U.S. trade or investment agreements experienced at least 7% declines in the value of their currencies vis-à-vis the U.S. dollar in 2008. Many are depleting reserves to prop up the value of their currency, a strategy that could further undermine investor confidence.

Some of Obama’s advisors are clearly enlightened on this issue. Daniel Tarullo, who led the President’s economic transition team, has been a strong critic of the capital control restrictions in U.S. trade policies. In Congressional testimony in 2003, he said, “Our government’s insistence on such provisions is bad financial policy, bad trade policy, and bad foreign policy.”

But Tarullo has landed on the Federal Reserve Board, rather than in the Treasury Department or the U.S. Trade Representative’s office, where he could’ve had a direct hand in changing the policy. USTR nominee Ron Kirk, the former mayor of Dallas, hasn’t spoken out on the issue. Treasury Secretary Timothy Geithner, on the other hand, has made his views quite clear. In a 2007 speech on the lessons of the Asian crisis, he warned that efforts to shield an economy from volatility through capital controls or other means “can be both futile and counterproductive” and will “bring additional risks.”

Not exactly encouraging, perhaps, but believing that capital controls are inadvisable is a far cry from believing that they should be prohibited. And in the year and a half since Geithner gave that speech, the world has changed. We can only hope that in this post-market fundamentalist world, he will see the wisdom of allowing governments more flexibility to chart their own paths to economic development and stability.

Geithner and other top Obama economic officials should open a dialogue with leaders in Bolivia, Ecuador, and other countries who are seeking to develop alternative rules for international investment and finance. They should commit to a new global framework that allows governments to act responsibly to ensure that these economic activities support people and the planet. A good first step for Obama’s economic team would be to catch up to the IMF and scrap capital control policies, which are clearly relics from a bygone era.

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Sarah Anderson, a Foreign Policy In Focus senior analyst, is the director of the global economy program at the Institute for Policy Studies. She is the author of the new report "Handcuffs in Financial Crisis: How U.S. Trade and Investment Policies Limit Government Power to Control Capital Flows.